Contango vs Backwardation

Differences Between Contango and Backwardation

A market is said to be in Contango (also known as forwardation) when the spot price is way lower than the forward price of a futures contract whereas a market is said to be in Backwardation when the spot price is higher than the forward price of the futures contract.

Backwardation and Contango are used to define the shape and structure of a forward curve in future markets. Backwardation and Contango are terms that are very often taken into use within commodity markets. Backwardation and Contango must not be confused as one term since these are two different terms that are used for the purpose of explaining the shape and structure of the forward curve for commodities like wheat, gold, silver, or crude oil. A market is said to be in Backwardation, when the spot price is higher than the forward price of the futures contract whereas a market is said to be in Contango (also known as forwardation), when the spot price is way lower than the forward price of a futures contract. Backwardation happens when the spot price is anticipated to be more expensive than the forward price of a futures contract whereas Contango happens when the spot price is anticipated to be less expensive than the forward price of a futures contract.

Backwardation-vs-Contango

What is Contango?

When the Spot Price of the underlying (St) is lesser than the Futures Price (Ft) at a particular point in time, the situation is called ‘Contango.’ So, if Brent Crude is at $50/barrel now (June 1st). The futures price, i.e., cost of the front-month futures contract on Brent Crude today, is $55/barrel (the futures price for June 27th on June 1st is $55/barrel), the Brent Crude Contract is said to be in Contango.

The spot and futures prices move the way they are supposed to, driven by demand-supply, news, etc. but at the expiration of the contract, the futures price and the spot price are the same. Contango is concerning a particular date and agreement. I hate to say it, but it’s become a popular notion of saying that the market is in Contango, in this case, Brent Crude. The June contract may be in a Contango, but the July Contract may not. The market is in Contango if all the futures contracts with different expirations have prices higher than the spot price.

Contango occurs when St< Ft, i.e., Spot Price at a time ‘t’ is lesser than the Futures Price at the time ‘t.’ The futures price could be that of the June or September or December contract, for example. In the above, it is concerning June.

Spot & Future Price 2

The June contract is said to be in Contango in this case.

Market Contango

The market is said to be in Contango in this case since all the contracts’ futures prices are higher than today’s spot price.

Normal Contango

This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E[St]< Ft). It is either a model-based curve or an imaginary curve. It is a function of expectations, which is an average coming out of probabilistic outcomes.

Concerning the above graph, if on June 1st, you expect the Spot Price on 27th to be less than $55/barrel, then it is considered Normal Contango as the Futures Price in June 1stfor June 27this $55/barrel. We’ll keep this concept out of the picture.

What is Backwardation?

When the Spot Price of the underlying (St) is greater than the Futures Price (Ft) at a particular point in time, the situation is called ‘Backwardation.’ So, if Brent Crude is at $50/barrel now (June 1st). The futures price, i.e., cost of the front-month futures contract on Brent Crude is $45/barrel today(the futures price for June 27th on June 1st is $45/barrel), Brent Crude is said to be in backwardation.

The spot and futures prices move the way they are supposed to, driven by demand-supply, news, etc. but at the expiration of the contract, the futures price and the spot price are the same. Here too, backwardation is also concerning a particular agreement on a specific date. Again I hate to say it, but it’s become a popular notion of saying that the market is in backwardation in this case, Brent Crude. The June contract may be in a Backwardation, but the July Contract may not. The June contract may be in a Backwardation, but the July Contract may not. The market is in backwardation if all the futures contracts with different expirations have prices higher than the spot price.

Backwardation occurs when St> Ft, i.e., Spot Price at a time ‘t,’ is greater than the Futures Price at a time ‘t.’ The futures price could be that of the June or September or December contract, for example. In the above, it is concerning June.

Spot & Future Price 1

Normal Backwardation

This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E[St]>Ft). It is either a model-based curve or an imaginary curve. It is a function of expectations, which is an average coming out of probabilistic outcomes.

Concerning the above graph, if on June 1st, you expect the Spot Price on 27th to be more than $45/barrel, then it is considered Normal Contango as the Futures Price on June 1st for June 27th is $45/barrel. We’ll keep this concept out of the picture.

Backwardation vs Contango Infographics

Let’s see the top differences between backwardation vs Contango along with infographics.

Backwardation-vs-Contango-infographics

Key Differences

Why does a Contango or Backwardation Happen?

One apparent reason is excessive demand or oversupply either for spot asset or futures, causing Contango or backwardation depending on the case.

Contango: 

Backwardation:

  • Convenience Yield (y): An industry or big companies may feel that there is going to be a shortage of a commodity say ‘oil.’ Thus, they indicate starting to increase their stockpile of oil barrels now rather than doing it in the future. They do not sell existing oil barrels in the fear that they may not be able to buy it in the future as it might be in shortage. This mood and momentum push the Spot Price up to, and lack of demand in the futures market pushes its price down relative to the spot. This is a ‘fear premium’ embedded in the spot price.
How does it become a yield?

Due to the fear of perceived future shortage, they don’t sell the asset as they may use it for production, etc. Note that it starts looking like an income-producing asset, although it doesn’t produce income!

  • S0 = $50/barrel
  • T = 1 year
  • r = 10% p.a. continuously compounded

Theoretically, the Futures Price given the above information should be $55.26/barrel i.e.,

  • = 50 * e(10%) * 1
  • = 55.26

But the actual futures price is $52/barrel. It looks like a Contango and an arbitrage play but because of the fear the equation turns around to become:

  • = 50 * e(10% – y%) * 1 
  • = 52

Using logs, we get

  • y% = 6.10% p.a.

Thus, the equation governing the Futures Price with respect to the Spot Price is as follows (when it is continuously compounded as is the convention)

F”t”= S”t” * e( r+c-y) * (T-t)

Where,

Backwardation vs Contango Comparative Table

Basis of comparisonBackwardationContango
DefinitionIt is a condition prevailing in the market when the future price of commodities such as wheat, crude oil, gold, or silver trade lower than the anticipated spot price. It usually takes place when the value determined as a result of reducing spot price from the futures price is lower than the COC or cost of carrying (that is when the spot price plus cost of carrying is higher than the forward price).It is a condition prevailing in the market when the future price of commodities such as wheat, crude oil, gold, or silver trade higher than the anticipated spot price. Contango is very common in the cases of commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more that are non-perishable and has a COC.
Spot priceA market in normal backwardation indicates that the spot price is higher as compared to the forward price of the futures contract.A market in Contango or forwardation indicates that the spot price is lower as compared to the forward price of the futures contract.
The forward price of the futures contractA market in normal backwardation indicates that the forward price of the futures contract is lower as compared to the spot price.A market in Contango or forwardation indicates that the forward price of the futures contract is relatively higher as compared to the spot price.
Why does it actually take place?There are various reasons as to why normal backwardation takes place. These reasons are convenience yield, excessive demand for futures or spot asset, oversupply for futures or spot asset, etc.There are various reasons as to why Contango or forwardation takes place. These reasons are COC, ROI or rate of interest, oversupply for futures or spot asset, financing costs, insurance costs, storage costs, excessive demand for futures or spot asset, etc.
The pattern of the forward price curveWhen a market in normal backwardation, the structure of the forward price curve is downward-sloping, indicating an inverted market.When a market in Contango or forwardation, the structure of the forward price curve is upward-sloping, indicating a normal market.
FrequencyIs usually rare.Is not a rare scenario.
Response in initial long futures position holderIt will result in a positive roll yield as an initial long futures position holder.It will result in a negative roll yield as an initial long futures position holder.
Response in initial short futures position holderIt will result in a negative roll yield as an initial short futures position holder.It will result in a positive roll yield as an initial short futures position holder.
Commodity markets Indicate that the forward price curve is sloping downwards.Indicate that the forward price curve is sloping upwards.

Conclusion

A backwardation and a contango market must not be confused with an inverted futures curve and normal futures curve, respectively. When a market is facing backwardation, then the shape of the forward price curve is sloping downward, which indicates that the market is pretty inverted, whereas when a market is facing Contango, then the shape of the forward priceThe Forward PriceA forward price is the agreed-upon future price at which a supplier will deliver an underlying financial asset or commodity to a customer. It is entirely determined by the spot price of an underlying financial asset, which includes all carrying costs such as foregone costs, interest, and so on.read more curve is sloping upwards, which indicates that the market is pretty normal.

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This has been a guide to Contango vs Backwardation. Here we discuss the top difference between Contango and Backwardation along with their meaning and comparative table. You can learn more from the following articles –

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Comments

  1. Jesson Taylor says

    Very informative. Most of the people don’t know about these two words Backwardation and Contango, to understand this you must have an idea about Futures and Forwards markets, but I must say the way you have specified this, it is really very easy to understand. Thanks for sharing this useful information.

  2. Sundar says

    Thanks for clarification of terms not used in my Career.

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